Are Comparisons of Active Managers to Passive Indexes Misleading Investors?
By Don Schreiber, Jr. - WBI Founder and CEO
(Printable PDF available below)
Get ready; it’s about to happen again. After July’s market close I expect to see headlines pummeling the performance of the so-called “average active manager” versus the passive S&P 500 Index. Recently, this debate has intensified as the elongated “Fed-fueled” bull market has continued to lift indexes to successive new highs with extremely low volatility. Conventional wisdom insists that markets are inherently efficient and, therefore, it is nearly impossible to consistently beat the market or passive indexes rendering active management obsolete. If higher-cost active managers can’t beat the passive index products all the time, then the theory suggests the only rational choice would be to minimize costs. Not so fast! The implications of this analysis are far too important and additional information may lead experts to a different conclusion.
The concept of comparing active management against the major market indexes seems ridiculous to me. Since the gauge of comparison is performance, why pit only the “average” active manager against an index? Maybe the media pundits use this comparison because an index's performance is nothing more than the weighted “average” performance of the underlying securities. I don’t know about you, but the last thing I want my manager or investment approach to be is “average.” If you are reasonably smart and willing to invest a little time in research, you should be able to quickly identify above-average managers that may be worth the higher fee they charge. Why seek to be average?
When the industry talks about active managers, they are typically referring to managers who use security selection and weighting to outperform a benchmark index. And if they can do so net of fee when compared to lower cost, passive cap-weighted index products then they add real value. However, lately, the discussion has been focused on performance over time periods of one month, one quarter and even one year, irrelevant when you consider how many Americans will invest for retirement over the course of 60-70 years. With almost 37 years in the industry, I believe the above average managers might have outperformed passive indexes by a large margin after fees over longer periods of time. To check this hypothesis, I decided to do a little research using the Morningstar U.S. domestic equity manager universe.
Over the years my colleagues and I have found the capture ratio to be a powerful screening criterion to determine the best managers. The calculation formula for capture ratio is upmarket capture ratio divided by downmarket capture ratio as compared to an index. For this analysis, I assumed an initial investment of $1,000,000 and kept all the managers who had a capture ratio of 1.0 or greater to the S&P 500 Index. The period 2000-2017 was used for this analysis because it includes two full market cycles of both bull and bear markets. The first capture ratio sort yielded approximately 2,000 actively managed products that were equal to or exceeded 1.0. To accurately compare to the S&P 500 Index, we selected the 252 actively managed products in the U.S. Equity Large Blend Morningstar Global Category Universe.
What we found may surprise you!
Source: Morningstar, Net of Fee, 1/1/2000 through 12/31/2017. Hypothetical $1,000,000 initial investment. Past performance does not guarantee future results. Indexes are unmanaged and cannot be invested in directly.
By analyzing full market cycles, we believe investors can make more informed decisions regarding the prudent blend of active and passively managed products in their portfolio allocations. A total of 174, or 69.05% of the actively managed products with a capture ratio of 1.0 or better, outperformed the S&P 500 Index, net of fees. The summary data in the chart also shows how the top 50% based on annualized return performed relative to the index broken down by decile. It would seem that active management can pay off handsomely, with the top 10% of managers producing a 9.71% average return, easily outstripping the 5.40% return generated by the index. Even more importantly, this group more than doubled the capital accumulation of the S&P 500 Index on average.
The problem with the passive indexing conclusion is not the eye-catching performance in up markets, but the massive losses incurred by investors in down markets. The S&P 500 Index suffered losses of 50% and 57% from market highs to market lows in the bear markets of 2000-2002 and 2007-2009,1 respectively. The “active vs. passive" debate of late leaves out this vital fact by making the comparisons only during bull market periods. As investor euphoria rises with the bull market trend, the one-sided comparison of passive indexing’s tendency to outperform in bull markets may lead investors to a faulty conclusion and cause them to position themselves for substantial losses when the bull market trend collapses.
While it takes a little more work to find better than average managers and products, my strongly held belief is that it’s the smarter way to go.
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Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr., and should not be construed as investment advice. Don Schreiber, Jr. or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.
Upmarket and Downmarket Capture Ratios: used to evaluate how well a manager performed relative to an index during periods when the index is up or down. Maximum Drawdown: measures the peak‐to‐trough loss of an investment, indicating capital preservation. Alpha: measure of risk-adjusted non-excess return; positive Alpha indicates performance better than the given Beta (volatility) of the investment. Net of Fee: The gross of fee return reduced by investment management fees.
1 "11 Historic Bear Markets." NBCNews.com, 24 June 2010.